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Tuesday, July 21, 2009

What exactly is the Margin of Safety?

The heading of Chapter 20 of Benjamin Graham's 'The Intelligent Investor' (4th edition) reads: "Margin of Safety" as the Central Concept of Investment.

What is the Margin of Safety as applicable to stock investments? It is the amount by which a stock's price is lower than the intrinsic, or underlying, value of the stock.

There are several methods by which one can arrive at the intrinsic value of a company's stock - and I plan to write a post about it in future. Suffice it to say that none of these methods can give an exact value. At best it will be a reasonably close approximation.

Here is a definition from the master:

'Over a ten-year period the typical excess of stock earning power over bond interest may aggregate 50% of the price paid. The figure is sufficient to provide a very real margin of safety - which, under favorable conditions, will prevent or minimize a loss. If such a margin is present in each of a diversified list of twenty or more stocks, the probability of a favorable result under "fairly normal conditions" becomes very large.'

Some terms may require a bit more explanation. By 'bond interest', Graham means yield from strong corporate bonds. Since the bond market in India is underdeveloped, we will use Fixed Deposit(FD) interest in a public sector bank as an equivalent guideline. 'Stock earning power' is the same as earnings yield, which is the inverse of the P/E ratio.

Enough talk. Time for some concrete examples.

(a) Company XYZ has declared its results and has an EPS (i.e. earnings per share, calculated by dividing the net profit by the number of equity shares) of 10. The recent market rally has taken the stock's price to 150. That gives a P/E ratio of 15.

The earnings yield is E/P= 1/15= 6.7%. This is lower than the current FD interest rate of 8%. The Margin of Safety is a negative 1.3% (=6.7-8). What does it mean? The current yield from the stock is less than that from a risk free FD.

(b) Company PQR also has an EPS of 10. But its price hasn't moved up as much as XYZ, and is currently trading at 100. The P/E is 10 and the earnings yield= E/P= 10%. The Margin of Safety is 2%. That gives an excess of only 20% over the FD interest, which doesn't meet Graham's criterion of 50% excess over a 10 year period.

(c) Company ABC has a lower EPS of 9, and its price is also lower at 63. The P/E is 7; earnings yield= E/P= 14%; Margin of Safety is 6%. This meets Graham's criteria, because the excess of stock earning power over FD yield is 60% over 10 years. The greater risk of owning the stock is adequately covered by the margin of safety.

Does it mean that you rush out to buy Company ABC? Not yet. You still have to perform a detailed fundamental analysis using Graham's criteria mentioned in my earlier blog post about stock picking (link given below).

These examples have been simplified by excluding the effects of inflation and any tax incidence. But the 'Central Concept of Investment' is de-risking your portfolio by maintaining adequate margin of safety for each stock that you select.

Even by using the Margin of Safety method, you may pick a stock or two that go down. That is why Graham has mentioned owning about 20 stocks, so that in aggregate, the portfolio will gain over the long term.

Graham passed away in 1976. How relevant are these figures and methods in today's environment? Apparently, they work just as well, as John Reese has mentioned in his book, The Guru Investor.

Individual investors can tweak the figures to suit their investment style and risk tolerance. Remember that it is just as important to protect the downside of your portfolio while you try to build long term wealth through stock investments.

For those readers, who are beginning to get a little tired of my exhortations towards the slow but steady value investing concept of wealth building, I have some good news.

By keeping a higher margin of safety, even fundamentally weak stocks can be bought when they sink to abysmal depths during bear markets. Just look at the prices of Satyam, Suzlon, Unitech when they hit their recent bottoms, and compare with current prices. But that would be succumbing to the 'greater fool' theory!

Related posts

How to pick Stocks for Investment - Part III
How to build wealth using a buy and hold strategy

4 comments:

scorpio said...

Great stuff sir. you made this very simple to understand. I was also reading your comments on cash flows for hind dorr - this has given me some work for this weekend, would like to learn more on how to read the cash flows. Your blog every week gives me a lot to think. Thanks again for sharing all your knowledge :)

Titu said...

Hello Sir,
First thanks for posting such a beautiful article explaining the most beautiful concept in stock investing.
But i still believe that satyam will not fit for that label as real balance sheet was not available at that time, (please excuse me if i am wrong), on other hand i think tata steel was good for investment at 140/- rs per share (even cmp also it look somewhat good) with div =16/-rs and eps=71.2/-rs, bv=370.

I hope you will currect me wherever i am wrong

Subhankar said...

@scorpio: Appreciate your comments. If you have any specific queries, feel free to write to me, or write a comment on the relevant blog post.

@Titu: Glad to note that you liked the post. About Satyam, the point was - if you keep an adequate margin of safety, you can buy any stock and still make a profit. (After the takeover by the Mahindras - things may turn around in a couple of years.)

Tata Steel is one of my favourite stocks. It was cheap at 140. It is reasonable even at 350-400.

Are you saying: why buy Satyam when Tata Steel is available for a reasonable price? If yes, then you are already thinking like a value investor for the long term!

Jasi said...

Dear Sir,

In this post you talked about penning another one around calculating intrinsic value of a stock or company.
If you have done so, would be kind enough to point me to it? If not, I think it would be great if you can jot down such a post.

Thanks and appreciate your efforts!
Jasi